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New York court says de facto merger rule not applicable when LLC transfers business to an individual

New York’s Appellate Division recently had to decide whether the “de facto merger” doctrine applied when an LLC transferred its business to a sole proprietor, i.e., to an individual person. The court concluded there could be no de facto merger because New York’s LLC Act does not authorize the merger of an LLC with an individual. Hamilton Equity Group, LLC v. Juan E. Irene, PLLC, 2012 WL 6720735 (N.Y. App. Div. Dec. 28, 2012).

The de facto merger doctrine, if applicable, allows an LLC’s creditor to assert its claims not only against the LLC but also against a successor to the LLC’s business. Under this doctrine, a court can treat the sale of a business as a merger between the buyer and seller. In that event, the buyer is liable for all obligations of the seller, even if the buyer only acquired the assets of the business and assumed none of its obligations. A number of factors are considered by the courts in determining whether a de facto merger has occurred, including continuity of ownership and management, and use by the buyer of the same assets, personnel and location. E.g., Sweatland v. Park Corp., 587 N.Y.S.2d 54 (App. Div. 1992).

Facts. Juan Irene practiced law as the sole member of Juan E. Irene, PLLC, a New York professional service limited liability company. The LLC entered into a line of credit with HSBC Bank in 2002, and defaulted on the loan in 2009. The LLC dissolved after the loan default, and Irene continued his law practice in his individual capacity at the same location where the LLC had been located. He also used a similar assumed name, “The Law Office of Juan Irene, Esq.” Personal injury cases that the LLC had been handling were transferred to Irene, and Irene conceded that the Bank had a security interest in a portion of the attorneys’ fees generated by those cases.

The Bank’s assignee brought suit on the loan against both the LLC and Irene personally. The trial court concluded that Irene was liable to the plaintiff as a “successor by merger” to the LLC, and ordered summary judgment for $124,984 against both the LLC and Irene personally. Hamilton Equity Group, 2012 WL 6720735, at *1. Irene appealed the judgment against him.

Court’s Analysis. The court began by noting that the New York doctrine of de facto merger was developed to protect shareholders and the claimants in products liability and breach of contract actions. The doctrine creates an exception to the general rule that a buyer of a company’s assets normally does not become responsible for the preexisting liabilities of the acquired company, unless it expressly assumes those obligations.

The court then examined New York’s LLC Act, which authorizes a professional service LLC to merge with another LLC, a foreign professional service LLC, or any “other business entity” formed under the laws of any state. N.Y. Ltd. Liab. Co. § 1216. “Other business entity” is defined as “any person other than a natural person or domestic limited liability company.” Id. § 102(v) (emphasis added). The court concluded that the statute’s plain language does not authorize a merger between an individual and a professional service LLC. Hamilton Equity Group, 2012 WL 6720735, at *2. (The same is true of LLCs that are not professional service LLCs. N.Y. Ltd. Liab. Co. § 1001(a).)

The court then ruled that because an LLC cannot carry out a statutory merger with an individual, the de facto merger rule could not apply when an LLC transfers its business assets to an individual. The court treated the de facto merger rule as if application of the rule would impose a merger on the parties: “Thus, even if defendant and the PSLLC desired to be merged, rather than having such merger imposed upon them by a judicially created doctrine, such a merger could not be accomplished under the Limited Liability Company Law.” Hamilton Equity Group, 2012 WL 6720735, at *2.

Finding that there was no de facto merger, the court reversed the judgment against Irene.

Comment. The court’s conclusion that people and LLCs can’t merge is completely conventional. But it is a little surprising that the court gave such short shrift to the policy behind the de facto merger doctrine. It is, after all, an equitable rule that disregards the form of a transaction in order to recognize its substance. If all the circumstances – continuity of management, continuity of ownership, the same assets, the same personnel, the same or similar name, same location, etc. – would result in treatment of the business acquisition as a “de facto merger,” why should it make a difference whether the buyer is Joe Doakes, an individual, or Joe Doakes’ single-member LLC? The doctrine should make the successor liable for the bank debt in either case.

The court did refer briefly to Tift v. Forage King Industries, Inc., 322 N.W.2d 14 (Wis. 1982), which the plaintiff had used in support of its argument, and rejected it. In Tift the Wisconsin court applied both the “amounts to a merger” rule and the “mere continuation” rule to a business acquisition where the predecessor business was a sole proprietorship, i.e., an individual. Id. at 14, 17. “[T]here is ‘identity,’ because in substance the successor business organization which the plaintiff sues is, despite organizational metamorphosis, the same business organization which manufactured the product which caused his injury.” Id. at 17. The Tift court applied Wisconsin’s version of the “de facto merger” rule and found the successor liable, even though the predecessor was an individual.

The Tift opinion makes a strong argument for disregarding the difference between an entity and a sole proprietorship when applying the de facto merger rule.